Monetary transmission in New Zealand : a VAR model

Abstract

The philosophy underlying New Zealand's monetary policy, since the introduction of the 1989 Reserve Bank Act, appears to subscribe to two basic propositions about the underlying nature of money. The first follows that of Milton Friedman's (1970) famous dictum that 'inflation is always and everywhere a monetary phenomenon', while the second relates to the natural rate hypothesis, that monetary policy has no impact on employment and output in the long run. These propositions imply a certain sequence of causality running among macreconomic variables, and the purpose of the study is to test this implicit dynamic sequence using data for output, money supply, price level, interest and exchange rates for the post-1984 period.

The methodology adopted uses a vector error correction model developed using Johansen's (1988) multi-equation technique and a reparameterised vector autoregression model in order to capture the within sample and out-of-sample Granger causality chain among the variables. Our evidence based on the Granger-casual chain is that real output relatively leads money supply and the other three endogenous variables. The evidence from the results are more consistent with the claims of Real Business Cycle theory, than of other competing paradigms such as Monetarist, Keynesian and Post Keynesian. The findings lead us to two conclusions, firstly money supply, interest rate, price and the exchange rate are subject to adjustments endogenously in order to accommodate for real shocks and secondly that excess money expansion is likely to be dissipated through higher nominal variables, in prices and exchange rates as opposed to real output.